Monday, January 9, 2012

My Dividend Retirement Plan

I invest in dividend stocks, in order to generate a sufficient income stream, that would meet and exceed my expenses in retirement. Retirement to me is the point where my dividend income exceeds my expenses, which means that I no longer have to work for money. I am a big proponent of value investing, which is why I would only consider myself financially independent whenever the dividend income stream generated by my portfolio exceeds 1.5 times my annual expenses.

In order to get there, there are several simple, but crucial principles I need to follow.

The first principle in building wealth through dividend paying stocks is to spend less than what you earn. I have consistently managed to save approximately half of my after-tax income every month. In addition, any bonus or raise received has been designated to my dividend growth portfolio. It also doesn’t hurt to try looking for additional income opportunities, which are dependent on my skillset. By investing as much as possible, I can grow my portfolio and the income stream it produces very quickly. In addition, by spending half of my salary for example and keeping expenses low, I would only need 50% less than what I currently make in terms of dividend income. In addition, regular saving helps me to consistently add to my portfolio. This regular dollar cost averaging over time into positions that are attractively priced, creates another layer of safety.

The second principle is to invest your money very conservatively. I invest my money as if I would lose my job and I would have to depend on my portfolio income for my sole purpose of survival. As a result I do not chase hot stocks or try to outsmart the market through frequent trading or market timing. I have designated a simple strategy, which fits my personality and which works for me. Since I have designated the strategy, and since I have had years of experience in the markets, I know when to look for an investment opportunity. I do continuously try to learn as much as possible about markets, investing and other strategies, in order to find ways to improve.

The third principle is somewhat similar to the second. It is all about designing an investment strategy and sticking to it for most of the part. My strategy entails:

1) Stocks that have a 10 year record of consistent dividend raises
2) P/E ratios of less than 20
3) Dividend payout ratios of less than 60%. For MLPs, REITs and Utilities I evaluate each opportunity on an individual basis
4) Dividend yield exceeding 2.50%, although I do change this requirement depending on the dividend yield on the S&P 500
5) Quality characteristics such as wide moat, strong competitive advantages, strong brand names, rising earnings, decreasing number of shares etc

While I mostly stick to my strategy, I sometimes do deviate from it. I have purchased companies yielding less than 2.50%, or ones which have had less than 10 years of consistent dividend increases. I have not purchased stocks whose P/E ratio was above 20 times earnings however. Valuation is paramount in my investment decision. I typically expect that the distributions from my dividend portfolio would grow organically by about 6% per year. In comparison, dividends on Dow Jones Industrials Average grew by over 5% per year between 1920 and 2005. The rising dividend stream will maintain purchasing power of my income stream by protecting it from inflation. The types of companies I invest in include such blue chips like Johnson & Johnson (JNJ) or PepsiCo (PEP).

The fourth principle involved selling underperforming shares. While I take a great amount of time analyzing companies and making sure they are priced right before I purchase them, I realize that things could change and that I should not be married to a stock that does not deliver results. In a previous article I mentioned that typically sell dividend stocks only after three events have occurred. One of these events includes dividend cuts. If a company whose stock I own lowers or eliminates dividend payment, I immediately sell and reinvest the proceeds into an investment from a similar sector that is priced attractively. For example, when I sold British Petroleum (BP) in 2010, I immediately purchased shares of Royal Dutch Shell (RDS/B). As a result, I was able to replace the dividend income to a certain extent, and still had exposure to the Energy sector.

The fifth principle is all about diversification. I try to maintain a diversified income portfolio, which has over 40 individual securities in it. The portfolio is not equally weighted, as it has been built over a long period of time. It includes a fair amount of underweight positions, which were accumulated when they were attractively valued, but are no longer fairly valued. Examples include Family Dollar (FDO) and Yum! Brands (YUM). The reason behind diversification is to ensure that the income stream is not severely affected when one or two of the stocks I own cut distributions. A dividend cut in a portfolio of less than 10 stocks will severely affect the income stream. A dividend cut in a portfolio of over 30 stocks will not affect the dividend income. In an equally weighted portfolio, even if the dividend is completely eliminated in one or two components, the total income can still grow if the other components grow distributions and if the sold stocks are replaced strategically.

The sixth principle of my wealth accumulation strategy is strategically reinvesting dividends. While I plan that my dividend growth portfolio will generate organic dividend growth of 6% per year, by reinvesting dividends, I can generate a much higher total growth in portfolio distribution income over time. Basically I am turbocharging my total dividend income by purchasing shares which rise dividend payments, then reinvesting these dividend payments and also adding new capital to the portfolio every single month. I typically wait for the amount of dividends and the amount of new capital to reach $1000 before I purchase a new or additional position in a given company. I do not automatically reinvest dividends, because I do not want to purchase additional shares in a company that overvalued.

In summary, by saving money, investing them in blue chip dividend growth stocks and reinvesting dividends and new capital, I plan to generate enough dividends to make me financially independent. I follow the six principles in my wealth accumulation and dividend income generation. My dividend income is getting closer to 40% - 45% of my expenses, after following these guidelines for a several years. In a few short years, my dividend income should be able to exceed my monthly expenses, without having to endure a lower standard of living.

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